WEALTH MANAGEMENT INVESTMENT RESOURCES
FEBRUARY 14, 2018
Geo-Markets SCOTT HELFSTEIN, PhD Morgan Stanley Wealth Management
[email protected] +1 212 296-2632 IAN MANLEY Morgan Stanley Wealth Management
[email protected] +1 212 296-0929
Market Impact
South Korea: Olympic Games
Probability
Market Impact
Israel: Domestic Instability
Probability
Market Impact
Germany: Coalition Ratification
Defense Spending and Asset Volatility This issue includes: •
US Congress approved a 15.5% increase in defense spending, but that does not mean flows to defense drive equity return.
•
Emerging and frontier markets have seen less volatility than the developed markets during the past two weeks.
•
Since 1992, equities of Olympic host countries outperformed the MSCI All World Country Index by an average 3.0% in the 12 months after the games.
•
Rising risk in Israel from internal and external pressures warrants near-term hedging.
•
If Germany’s grand coalition agreement is approved next month, the increased fiscal stimulus would be positive for European equities and riskier European sovereign bonds.
•
Geo-Dashboard: Except for China, the past two weeks’ worst performers do not match last 12 months’ worst performers, a rare disconnect (see page 5).
Assets: Defense Sector
US BUDGET Risks of Overplaying the Defense Spending Increases
Action: Neutral
On Feb. 3, Congress approved a budget agreement, which was signed by the president, to end the second government shutdown this year. The bill calls for a $400 billion two-year spending increase. The biggest beneficiary appears to be the military, with a 15.5% increase, according to the Associated Press. This may look like a win for the defense sector, but investors should proceed with caution. A 15.5% lift for the Pentagon would be the biggest annual budget gain since 2003 and the largest since 1982. In 2003, a 16.4% increase translated to a 20.7% return for defense stocks. One might assume that investors can benefit from the budget pact, but long-term trends suggest otherwise. US military spending has increased approximately 5% per year since 1960. Since 1990, when the S&P Aerospace and Defense Index began, the index has underperformed in years with substantial increases in defense spending -relative to years when there was a lesser spending increase. Specifically: when defense spending increased by more than 5%, the index was up an average 8.0%.
Probability Morgan Stanley Wealth Management is the trade name of Morgan Stanley Smith Barney LLC, a registered broker-dealer in the United States. This material has been prepared for informational purposes only and is not an offer to buy or sell or a solicitation of any offer to buy or sell any security or other financial instrument or to participate in any trading strategy. Past performance is not necessarily a guide to future performance. Please refer to important information, disclosures and qualifications at the end of this material.
GEO-MARKETS
FEBRUARY 14, 2018
There are many reasons why this unexpected relationship persists. Many military projects require years, perhaps a decade or more, in development before they generate significant revenue. In addition, personnel represent a significant cost for the military, and increasing the size of the armed forces and raising the pay will likely absorb some of the budget increases. The fundamentals may be good for owning the defense sector, and performance for the group has been excellent in recent years, but additional defense spending alone is not a sufficient reason to increase one’s allocation. Defense community signaling suggests cybersecurity, naval capabilities, space and unmanned capabilities could get a disproportionate share of the increased dollars. Conclusion: Higher levels of US defense spending do not necessarily translate to share-price appreciation across the sector
Assets: EM Equity
Exhibit 1: Increases in Defense Spending Have Not Driven Defense Sector Returns S&P 500 Aerospace & Defense Industry Return
When spending grew less than 5%, the sector rose more than 14.0% on average. Exhibit 1 shows a modest inverse relation between military spending and the defense sector’s performance.
80 % 60 40 20 0 -20 -40 -60
-10 %
-5 0 5 10 15 Change in Military Expenditures
Note: Based on annual data from 1990 through 2016 Source: Bloomberg
and investors should be cautious about such an argument. Some parts of the defense sector stand to benefit more than others.
EMERGING MARKETS
Action: Diversification
Emerging Insulation from Volatility Spike
In US markets, the S&P 500 30-day real volatility rose to 21.0 after starting the year at an unusually low 6.7, marking a 215% increase by Feb 8 (see Exhibit 2). Many global markets sold off, too. Real volatility on the Euro STOXX 600 Index spiked 81% in the same time, but emerging markets volatility picked up a more modest 30%. Some frontier markets have actually seen volatility decline despite the US selloff. Frontier markets can offer a refuge from developed markets volatility. Drawdowns in emerging markets may be equivalent to those in developed markets, but the swings have been less severe. For example, in August-September 2015, when US 30-day volatility increased 183%, emerging markets volatility was up 86% and frontier markets, 81%. There was a similar response in 2011, when emerging and frontier markets volatility increased 107% and 48%, respectively, compared to the S&P 500’s 197%. A total of 21 emerging and frontier exchanges gained or lost no more than 2% during the six-day selloff. Exhibit 2 shows the list of exchanges that saw the largest and smallest moves in 30-day volatility. Frontier markets have typically displayed a lower correlation to US equities. This offers a reason to consider emerging and frontier markets in portfolios that lack that exposure.
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Conclusion: Emerging and frontier markets experienced a smaller spike in volatility then the US large caps. Lower levels of volatility in emerging and frontier markets suggest that many global investors still believe there is a relatively strong economic outlook globally. This sentiment could ultimately help stabilize the markets.
Exhibit 2: Volatility Pick-Up Unequal Biggest Gain Lithuania US Ukraine Bulgaria Australia Colombia Belgium Ghana New Zealand Finland
288.2% 215.3 175.2 168.3 153.6 152.9 115.9 106.8 102.9 90.6
Smallest Gain -17.2% Namibia Laos -17.7 Latvia -20.3 UAE -25.8 Peru -27.4 Mauritius -29.7 Kenya -33.2 Malta -43.5 Chile -58.4 Mongolia -69.8
Daily data, Jan. 2 through Feb, 8, 2018 Source: Bloomberg Please refer to important information, disclosures and qualifications at the end of this material.
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GEO-MARKETS
Assets: South Korea Equity
FEBRUARY 14, 2018
SOUTH KOREA Olympic Gains
The impact of large sporting events on local and national economies generates tremendous debate. Supporters argue events like Olympic Games and World Cup draw billions to the local economy in development and tourism. Detractors suggest that much of the money goes to facilities that are left to deteriorate and provides little lasting economic benefit. With all eyes on South Korea at the start of the games, we look to the equity markets. Economists have more recently taken a pessimistic view of these sporting events. While the actual impact of events is difficult to measure, existing studies suggest that many believe subsidies to attract sports are a poor use of resources according to Dennis Coates and Brad Humphreys in Journal of Policy Analysis and Management. John Siegfried and Andrew Zimbalist in the Journal of Economic Perspectives go further, suggesting that there is little benefit from building stadiums to host these events.
Asset Class: Israeli Equities
As for the Olympics, countries that hosted the event since 1992 outperformed the MSCI All World index by an average of 3.0% over the subsequent 12 months. The same countries underperformed the index by 4.4% in the prior 12 months. Since 1972, hosts with an investable stock index returned 13.3% in the next year compared to gains of just 5.5% in the year before the games. Host country indexes produced positive returns a year after the games in 13 of 19 cases during that time. Conclusion: While we prefer fundamental justifications for market behavior, anecdotal research around Olympic Games suggests that South Korea could be a beneficiary of post-event bias. This is especially true if the detente with the North progresses following the visit from Kim Jong-un’s sister for the opening events.
ISRAEL Delving Into Syrian Conflict
An Israeli fighter jet was downed in Syria on Feb. 10, the first such event in 30 years. This came after an Iranian drone crossed into Israeli airspace. With tensions flaring in Gaza, Israel looking to weaken the Iranian position in Syria and now, the police recommending corruption charges against Prime Minister Benjamin Netanyahu, investors should be cautious. The plane was shot down as Israel targeted the growing Iranian military presence in southern Syria, specifically the operational base for the drone. The raid was far reaching, targeting 12 sites. The plane was the third aircraft downed over Syria this month, following attacks that brought down a Russian jet in the north and a Turkish helicopter near Kurdish territory. This reflects a new and troubling concern in Syria following the territorial defeat of the terrorist group ISIS. All sides in the simmering proxy war, despite different end goals, viewed ISIS as a common enemy. The Syrian regime, Shia Iranian allies and Russian backers saw the terrorist group as a threat to the Assad government. The US, Turkish allies and regional Middle East governments believed that terrorist attacks could emanate from ISIS-controlled territories. With ISIS unseated, and the sense of common purpose receding, the contradictory end games become more significant.
Action: Long
Action: Near-term Hedge
Both Iran and Hezbollah gained significant footholds in southern Syria during the civil war. While Israel conducts raids on Hezbollah with some frequency, moves against the Iranian presence could open a new chapter in hostilities. This will put the Russians, who have maintained good relations with both Iran and Israel, in a precarious position given the colocation of Iranian and Russian forces. This could constrain future Israeli action, but represents a potential ignition point. Meanwhile, Israel faces the mounting risk of unrest in Gaza as financial conditions there deteriorate. Economic challenges in Gaza stem partially from the split between the Hamas and Palestinian Authority. Hamas expelled the Palestinian Authority from Gaza in 2007, and the United Nations has warned that the territory is near collapse. This represents a potential internal challenge for Israel as the external tensions simultaneously mount. Conclusion: Investors should approach Israel cautiously in the near term. Long-term growth potential remains strong given the emphasis on technology start-up culture, but the potential for stepped-up external military activity and domestic risks in Gaza could warrant hedging or neutral positions.
Please refer to important information, disclosures and qualifications at the end of this material.
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Asset Class: Europe Equity & Peripheral Bonds
FEBRUARY 14, 2018
GERMANY Coalition of the Willing
On Feb. 7, German Chancellor Angela Merkel’s Christian Democratic Union (CDU) reached a coalition agreement with the Christian Social Union (CSU) and the Social Democratic Party (SPD), ending five months of uncertainty about the future of Germany and by extension, the European Union. The agreement must still be ratified by SPD members on March 4. While Merkel remains weaker than she was prior to the election and the post-war German political consensus frays, this is a positive development for European risk assets. If the coalition holds, expect more fiscal stimulus in Germany and across Europe, which will be positive for regional equity and periphery bond markets. This would also raise the profile of nationalist Alternative for Germany party by formally becoming the opposition. If the SPD members reject it, Germany will likely hold new elections and extend the existing political uncertainty, a risk for European equities. A survey of 5,127 voters conducted by pollster Civey indicates 60% of SPD supporters back the coalition. One positive from the agreement is that the conservative CDU’s Finance Minister Wolfgang Schaeuble, who championed fiscal austerity in Europe, will be replaced by the SPD’s Olaf Scholz. The coalition framework calls for more spending on education and infrastructure, and the result of a changing of Germany’s ministerial guard would be a dramatic shift to fiscal stimulus and away from fiscal restraint. As a creditor to many European capitals, this means easier money for peripheral European countries as well. After the news of the coalition pact, sovereign
Action: Long
bond spreads compressed: 10 basis points in Portugal, six in Spain, nine in Italy and 11 in Greece. Higher yielding European sovereigns are likely to do well if the coalition government takes control. Merkel has been a big proponent of the EU through difficult times, and will likely push towards further integration with new coalition partners. Drifting support away from both Merkel and the traditional parties may complicate such initiatives as nationalist or anti-integration forces gain strength. This does not mean European integration grinds to a halt. French President Emmanuel Macron laid out his plans in September for reforming the EU, including a common budget and fiscal policy. His proposal singled out Germany for championing EU reform. The coalition agreement dedicated the first three pages to strengthening the capacity of the EU and affirmed a desire to increase cooperation with the French government. A common fiscal policy would add a new macroeconomic lever to use in a downturn. Integration in banking and the legal framework would also reduce risk of a systemic event. Conclusion: We suggest being long European equities, particularly France and Germany, as well as peripheral government bonds. If the SPD fails to ratify the agreement on March 4, such a strategy likely underperforms.
Please refer to important information, disclosures and qualifications at the end of this material.
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Regional Cross-Sector Returns Sector Cons. Disc. Cons. Stap. Energy Financials Healthcare Industrials Materials Tech Telecom Utilities
Pacific Two Week Year to Date -5.7% 1.0% -6.3 -2.2 -10.9 -6.7 -7.6 -2.7 -5.0 1.0 -8.7 -1.1 -9.3 -4.0 -10.2 -1.6 -5.3 -0.9 -5.8 -3.2
Latin America Two Week Year to Date -11.4% -5.6% -8.0 -2.6 -9.7 13.5 -10.1 11.0 -9.9 -1.2 -8.9 0.5 -7.1 3.1 -13.1 3.3 -7.0 2.6 -6.4 0.9
Europe Two Week Year to Date -6.5% -2.7% -6.9 -8.2 -10.1 -7.4 -7.3 -1.5 -9.8 -7.9 -8.3 -5.5 -8.8 -5.3 -6.8 -3.9 -9.8 -9.4 -8.6 -9.6
Two Week -7.5% -8.7 -14.2 -8.2 -10.4 -8.6 -8.9 -8.3 -6.9 -4.9
US Year to Date 2.1% -5.8 -7.9 -1.1 -0.9 -2.4 -3.6 -0.1 -6.5 -7.8
Two Week -7.3% -8.3 -13.2 -8.3 -10.2 -8.9 -9.7 -8.4 -8.0 -6.6
World Year to Date 1.2% -5.6 -7.9 -1.3 -2.0 -2.6 -3.9 -0.3 -5.8 -7.3
Source: Bloomberg, Morgan Stanley Wealth Management as of Feb. 9, 2018.
Best Performers
Worst Performers
Last Two Weeks Ghana 6.99% 4.88 Zambia Tunisia 2.04 1.85 Sri Lanka 1.15 Cyrprus 1.00 Jamaica 0.91 Laos Morocco 0.66 0.59 Lebanon Mauritius 0.13
Last Two Weeks -14.19% Argentina China -12.04 Hong Kong -10.98 Vietnam -10.00 Japan -9.51 Germany -9.24 South Africa -9.24 Spain -8.83 Switzerland -8.76 United States -8.73
Last 12 Months Ghana 82.4% 77.6 Nigeria 76.6 Mongolia 57.4 Argentina Kazakhstan 52.0 Kenya 50.9 Zambia 48.9 47.0 Vietnam Greece 38.0 Latvia 34.3
Last 12 Months Qatar -13.8% Croatia -12.52 Pakistan -12.16 Oman -9.75 Malta -4.10 Laos -2.49 -0.57 Canada -0.31 Luxembourg Sweden 0.31 China 0.88
Green/red indicates a country is in the top/bottom 10 of world equity index total returns in local currencies for both the past two weeks and the past 12 months. Source: Morgan Stanley Wealth Management as of Feb. 9, 2018.
Top 10/Bottom 10 Global Equity-Macro Correlations 10-Year US Treasury
US Dollar
Oil
Gold
Colombia
0.56
Egypt
0.33
South Korea
0.61
Ghana
0.56
United States
0.52
Cyprus
0.33
China
0.59
Singapore
0.49
Bahrain
0.51
Zambia
0.32
Ghana
0.54
Morocco
0.48
Brazil
0.49
Laos
0.29
Hong Kong
0.54
Hong Kong
0.47
0.29
Chile
0.37
Canada
0.31
UAE Jamaica
Argentina
0.51
Greece
0.46
0.23
Thailand
0.50
Thailand
0.45
Sweden
0.28
Denmark
0.20
Singapore
0.49
Mexico
0.43
Phillipines
0.28
Sri Lanka
0.19
Brazil
0.48
Romania
0.42
New Zealand
0.26
Kuwait
0.19
Greece
0.48
India
0.42
Ireland
0.25
Phillipines
0.17
South Africa
0.48
Kuwait
0.41
Bulgaria
-0.23
Thailand -0.43
Lebanon
-0.04
Egypt
-0.08
Israel
-0.25
Singapore -0.43
Kuwait
-0.05
UAE
-0.12
Saudi Arabia
-0.28
Colombia -0.44
UAE
-0.06
Cyprus
-0.12
Hong Kong
-0.30
Serbia -0.48
Croatia
-0.09
Bahrain
-0.12
Poland
-0.33
Morocco -0.49
Egypt
-0.20
UAE
-0.14
Croatia
-0.36
South Korea -0.50
Sri Lanka
-0.23
Tunisia
-0.15
China
-0.41
Argentina -0.54
UAE
-0.26
Lithuania
-0.18
Jamaica
-0.45
Brazil -0.56
Denmark
-0.27
New Zealand
-0.21
Zambia
-0.46
Peru -0.60
Zambia
-0.40
Laos
-0.24
Ghana-0.65
Laos
-0.43
Phillipines
-0.26
Kuwait -0.54
Note: Calculated using correlation of 30-day rolling returns on 82 global equity indexes. Source: Morgan Stanley Wealth Management, Bloomberg as of Feb. 9, 2018 Please refer to important information, disclosures and qualifications at the end of this material.
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Probability of +5%/-5% One-Month Change in Global Asset Prices 60% 38
40
28 26
20
21 18 18 18 17 17 16 15 15 15 14 14 13 13 13 13 12 11 11 11 11 10 10 10 9
9
8
8
8
8
8
7
7
7
7
6
6
6
6
6
5
4
3
3
2
2
0
0
0
0
0
Note: Probability of a +5%/-5% move calculated using implied probability on ETF options by calculating the standard deviation on month expiration call contracts and using the prior day close for the mean. Source: Morgan Stanley Wealth Management as of Jan. 26, 2018
Global Hotspots Additional Risks: Cybersecurity Space Climate Change Proliferation Global Health
Germany: Shifting Political Consensus US: Polarized Politics
Canada/Mexico /US: NAFTA Renegotiation
Mediterranean/ EU: Refugees Ukraine: Civil Violence
UK: Brexit; Scottish Referendum
Iran: Nuclear Agreement
Spain: Catalonia
Civil Violence: Algeria/Mali Cent. African Rep. Congo Nigeria Somalia Sudan
No. Central America: Criminality
Af/Pak: Extremism
Japan: Military Policy Shift
China: NPC Aftermath Philippines: Counter Narcotics
Libya: Warlords Yemen: Civil War Brazil: Presidential Approval; Lula Return
Venezuela: Collapsing Regime
North Korea: Nuclear Crisis
Turkey: EU Relations PostCrackdown
Austria/Bulgaria/ Romania/Hungary: Nationalist Governance Mexico: 2018 Presidential Election
Russia: External Interests
Argentina: Economic Modernization; Kirchner Return
India: Reforms and Election
Saudi Arabia: Succession Syria: Civil War; ISIS
Iraq: ISIS; Kurdish Separatism
South China Sea: Island Building Thailand: Military Regime
Source: Morgan Stanley Wealth Management as of Feb. 9, 2018.
Media and Internet Search Scores on Political Violence
Source: Morgan Stanley Wealth Management, GDELT(Google Database of Events, Language and Tone). Indicates the number of global news articles about material conflict published in the past two weeks. Top 15 investable markets as of Feb. 9, 2018. Please refer to important information, disclosures and qualifications at the end of this material.
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Definitions The S&P Aerospace and Defense Index comprises stocks in the S&P Total Market Index that are classified in the GICS aerospace & defense sub-industry. For other index, indicator and survey definitions referenced in this report please visit the following: http://www.morganstanleyfa.com/public/projectfiles/id.pdf
Risk Considerations Investing in commodities entails significant risks. Commodity prices may be affected by a variety of factors at any time, including but not limited to, (i) changes in supply and demand relationships, (ii) governmental programs and policies, (iii) national and international political and economic events, war and terrorist events, (iv) changes in interest and exchange rates, (v) trading activities in commodities and related contracts, (vi) pestilence, technological change and weather, and (vii) the price volatility of a commodity. In addition, the commodities markets are subject to temporary distortions or other disruptions due to various factors, including lack of liquidity, participation of speculators and government intervention. Physical precious metals are non-regulated products. Precious metals are speculative investments, which may experience short-term and long term price volatility. The value of precious metals investments may fluctuate and may appreciate or decline, depending on market conditions. If sold in a declining market, the price you receive may be less than your original investment. Unlike bonds and stocks, precious metals do not make interest or dividend payments. Therefore, precious metals may not be suitable for investors who require current income. Precious metals are commodities that should be safely stored, which may impose additional costs on the investor. The Securities Investor Protection Corporation (“SIPC”) provides certain protection for customers’ cash and securities in the event of a brokerage firm’s bankruptcy, other financial difficulties, or if customers’ assets are missing. SIPC insurance does not apply to precious metals or other commodities. Bonds are subject to interest rate risk. When interest rates rise, bond prices fall; generally the longer a bond's maturity, the more sensitive it is to this risk. Bonds may also be subject to call risk, which is the risk that the issuer will redeem the debt at its option, fully or partially, before the scheduled maturity date. The market value of debt instruments may fluctuate, and proceeds from sales prior to maturity may be more or less than the amount originally invested or the maturity value due to changes in market conditions or changes in the credit quality of the issuer. Bonds are subject to the credit risk of the issuer. This is the risk that the issuer might be unable to make interest and/or principal payments on a timely basis. Bonds are also subject to reinvestment risk, which is the risk that principal and/or interest payments from a given investment may be reinvested at a lower interest rate. Bonds rated below investment grade may have speculative characteristics and present significant risks beyond those of other securities, including greater credit risk and price volatility in the secondary market. Investors should be careful to consider these risks alongside their individual circumstances, objectives and risk tolerance before investing in high-yield bonds. High yield bonds should comprise only a limited portion of a balanced portfolio. Yields are subject to change with economic conditions. Yield is only one factor that should be considered when making an investment decision. Equity securities may fluctuate in response to news on companies, industries, market conditions and general economic environment. Companies paying dividends can reduce or cut payouts at any time. Investing in smaller companies involves greater risks not associated with investing in more established companies, such as business risk, significant stock price fluctuations and illiquidity. Stocks of medium-sized companies entail special risks, such as limited product lines, markets, and financial resources, and greater market volatility than securities of larger, more-established companies. The indices are unmanaged. An investor cannot invest directly in an index. They are shown for illustrative purposes only and do not represent the performance of any specific investment. The indices selected by Morgan Stanley Wealth Management to measure performance are representative of broad asset classes. Morgan Stanley Smith Barney LLC retains the right to change representative indices at any time. Credit ratings are subject to change. Because of their narrow focus, sector investments tend to be more volatile than investments that diversify across many sectors and companies. Technology stocks may be especially volatile. Risks applicable to companies in the energy and natural resources sectors include commodity pricing risk, supply and demand risk, depletion risk and exploration risk. Rebalancing does not protect against a loss in declining financial markets. There may be a potential tax implication with a rebalancing strategy. Investors should consult with their tax advisor before implementing such a strategy. Investing in foreign emerging markets entails greater risks than those normally associated with domestic markets, such as political, currency, economic and market risks. Investing in foreign markets entails greater risks than those normally associated with domestic markets, such as political, currency, economic and market risks. Investing in currency involves additional special risks such as credit, interest rate fluctuations, derivative investment risk, and domestic and foreign inflation rates, which can be volatile and may be less liquid than other securities and more sensitive to the effect of varied economic conditions. In addition, international investing entails greater risk, as well as greater potential rewards compared to U.S. investing. These Please refer to important information, disclosures and qualifications at the end of this material.
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risks include political and economic uncertainties of foreign countries as well as the risk of currency fluctuations. These risks are magnified in countries with emerging markets, since these countries may have relatively unstable governments and less established markets and economies. Certain securities referred to in this material may not have been registered under the U.S. Securities Act of 1933, as amended, and, if not, may not be offered or sold absent an exemption therefrom. Recipients are required to comply with any legal or contractual restrictions on their purchase, holding, and sale, exercise of rights or performance of obligations under any securities/instruments transaction.
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Please refer to important information, disclosures and qualifications at the end of this material.
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